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Chapter 6. Corporate Operation-Survival Skills in Accounting and Financial Management

Chapter 6. Corporate Operation-Survival Skills in Accounting and Financial Management

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100 ◾



Entrepreneurship for Engineers



Once the company gradually expands, financial decisions must be made in various situations:

Shall we invest to set up a new manufacturing line? Shall we issue new stocks or acquire a ba nk

loan to collect necessary money for the company growth? We will consider these financial issues

in the latter part of this chapter.

From an engineer’s viewpoint, accounting and finance are rather similar—both work with

money—but their differences found in the mathematical formula seem to lie in the concept “time

is money”; that is, the time value of money (present value of future $1 and future value of present $1).

Accounting t reats m oney i n t he sh ort ter m, w hile fi nancial m anagement t reats m oney i n t he

long term.



6.1 Accounting Management—Sales and Payroll

Most small fi rms u se a p rofessional accounting offi ce for official accounting documents such

as a corporate tax return form. However, it is too costly to enlist the services of a professional

accounting o ffice for daily bookkeeping, and thus it is recommended that this task be conducted in your firm, by you or an office manager. There are many computer software programs

for small business accounting: Quickbooks, Microsoft Money Plus, BusinessVision32, and so

forth, most of which are based on Microsoft Excel functions. Figure 6.1 shows an introductory

page of Quickbooks. Be sure to use the same accounting software as the one your accounting

office uses, or follow the recommendation by the accounting office. We will start with the bookkeeping basics.



Figure 6.1



Introductory page of Quickbooks.



Corporate Operation—Survival Skills in Accounting and Financial Management







101



6.1.1 Daily Accounting

6.1.1.1 Product Costs and Period Costs

Both product and period costs should be considered “costs” in accounting [1]. A product cost (or

inventoriable cost) is a cost assigned to goods that were either purchased or manufactured for resale.

The product cost is used to value the inventory of manufactured goods or merchandise until the

goods are sold. In the period of the sale, the product costs are recognized as an expense called cost

of goods sold .The cost of goods sold is equal to the product cost (identified with the goods “sold”).

The product cost of manufactured inventory includes all of the costs incurred during its manufacture. The product cost for a retailer (e.g., the sales division of Micro Motor Inc. [MMI]) is equal

to the cost of purchase plus the cost of transportation. The product cost for a manufacturer (e.g.,

the research and development [R&D] department of MMI) is equal to the manufacturing cost.

Manufacturing cost includes the following:

1. Direct material: Raw material that is consumed during the manufacturing process

2. Direct labor: The cost of salaries, wages, and fringe benefits for personnel who work directly

on the manufactured products

3. Manufacturing overhead: All other costs of manufacturing; indirect material, indirect labor

(salaries of production department supervisors, etc.), and other manufacturing costs. Other

manufacturing costs include:

a. Depreciation of plant/equipment

b. Property taxes, insurance

c. Utilities (electricity, water, etc.)

d. Service/support departments (equipment maintenance, etc.)

All costs that are not product costs are called period costs. Period costs are recognized as expenses

during the time period in which they are incurred. General R&D, selling (salaries, commissions,

and travel costs of sales personnel, and the costs of advertising and promotion), and administrative

costs (salaries of corporate executives, costs of the accounting, legal, and public relation activities)

are treated as period costs.



6.1.1.2 Recording Journal Entries in the Ledger

Now let us consider the journal entry process into the ledger using an example case from MMI.

MMI received a purchase order of 20 pieces of ultrasonic metal tube motors (refer to Figure P1.1),

and planned to manufacture 25 pieces (5 extra pieces are made in case there are deficits; these may

be sold in the future), starting from the raw materials (lead zirconate titanate [PZT] ceramic plates

and metal tubes). The quote was issued for $14,000 in total (20 pieces at $700 per unit). The starting date was June 1, 20XX, and the due date was June 30 (i.e., 30 days). Ledgers typically contain

three successive steps in product manufacturing:









W

ork-in-process inventory

F

inished-goods inventory

Cost of goods sold



We will consider debit and credit relations for each inventory/process (this is called double-entry

bookkeeping ).



102 ◾ Entrepreneurship for Engineers



6.1.1.2.1 Purchase of Material

MMI purchased raw materials (PZT ceramic plates and metal tubes) from an outside supplier on

June 1. The purchase is recorded with the following journal entry: raw-material inventory has PZT

and metal materials (debit), and MMI owes $2500 to the supplier (credit).

Journal Entry 1



Debit



Raw-material inventory



Credit



2500



Accounts payable



2500



6.1.1.2.2 Use of Direct Material

On June 1, 20XX, the material requisitions were submitted, and the motor assembly started.

Journal Entry 2



Debit



Work-in-process inventory



Credit



2000



Raw-material inventory



2000



Note that direct materials cost is proportional to the number of products manufactured.

Direct material cost = Unit materials cost × Number of products manufactured

= $80 × 25 pieces = $2000



(6.3)



Extra materials were purchased in case of manufacturing loss or waste. If the materials can be used

in the next manufacturing lot, the raw materials can remain in the raw-material inventory.



6.1.1.2.3 Use of Direct and Indirect Labor

At t he en d o f J une, t he c ost-accounting depa rtment u ses t he l abor t ime re cords fi led d uring

the m onth to de termine t he d irect-labor c osts. M MI sp ent 5 0% o f t he t ime o f o ne en gineer

($25/h × 100 h/month at monthly salary of $5000) for the motor manufacturing. The direct labor

should also include fringe benefits such as health insurance and pension contributions from MMI,

which are about 20% of the salary.

D

irect labor = $5000 × 50% × (1 + 0.20) = $3000

Note that direct labor cost is proportional to the amount of working time.

D

irect labor cost = Unit labor cost and fringe (per hour) × Number of working time (hours)

= $25 × 1.20 × 100 hours = $3000

(6.4)

The production supervisor’s s alary (the R& D d ivision d irector i n M MI), which i s not c harged

to any particular job, is indirect l abor. O ther e xamples would i nclude c ustodial employees a nd

security guards, but these will not be relevant to a sm all enterprise. Since the director takes care

of five projects, he or she might spend 20% of their time for this task (monthly salary of $10,000

with 20% of fringe benefit).

ndirect

I

labor = $10,000 × 20% × (1 + 0.20) = $2400



Corporate Operation—Survival Skills in Accounting and Financial Management



Journal Entry 3



Debit



Work-in-process inventory



3000



Manufacturing overhead



2400



◾ 103



Credit



Wages payable



5400



6.1.1.2.4 Application of Manufacturing Overhead

Manufacturing overhead includes the following general and administrative (G&A) fi xed costs:













Rent on factory building—$1500 per month

Depreciation on equipment—$1000 per month

Utilities (electricity, gas, water, etc.)—$300 per month

Property taxes—$200 per month

Insurance—$300 per month (= $3600/12 months)

− Total—$3300



Since MMI is running fi ve projects, manufacturing overhead for this project can be considered

$3300/5 = $660. The manufacturing overhead costs are not traceable to any particular job.

Journal Entry 4

Manufacturing overhead



Debit



Credit



660



Prepaid rent



300



Accumulated depreciation—equipment



200



Prepaid utilities



60



Prepaid property taxes



40



Prepaid insurance



60



Various manufacturing overhead costs were incurred during June, and these costs were accumulated by debiting the manufacturing overhead account. However, in order to issue a quote to the

customer b efore s tarting t he m otor m anufacture, t he a bove p rocedure i s n ot v ery c onvenient.

Because we do n ot k now h ow m uch t he a ctual m anufacturing o verhead w ill b e, M MI u ses a

so-called predetermined overhead rate. Costs incurred for the above example are as follows:

◾ Direct materials and labor costs = $2000 + $3000 = $5000

◾ Manufacturing overhead (indirect labor and G&A) costs = $2400 + $660 = $3060

◾ O

verhead costs/direct costs = $3060/$5000 = 61.2%

MMI u ses t he predetermined overhead rate of 69.5% averaged over a c ouple of ye ars, which is

slightly l arger t han t he a bove pa rticular e xample. R efer to M MI’s Sa les C alculator S oftware

introduced in Chapter 4, Section 4.4.5.



104 ◾



Entrepreneurship for Engineers



6.1.1.2.5 Selling and Administrative Costs

During June, MMI incurred selling and administrative costs for this particular project as follows:











Salaries of sales personnel: 5 h at $12/h = $60

Salaries of management: 2 h at $60/h = $120

Promotion and advertising: $100

Office supplies used: $20



Note that selling and G&A costs are period costs, not product costs. Thus, the period costs are not

included in cost of goods manufactured or sold. Also note that these costs seem to be fixed costs

(regardless of the production amount, but just for one project) in MMI’s case.

Journal Entry 5

Selling and G&A expenses



Debit



Credit



300



Wages payable



180



Accounts payable

(advertisement)



100



Office supplies inventory



20



6.1.1.2.6 Completion of Production

The motor manufacture (25 pieces) was completed in June. The following journal entry records

the transfer of these job costs from work-in-process inventory to fi nished-goods inventory. Note

that we use the predetermined overhead rate (rather than the actual manufacturing overhead) in

this stage (direct cost $5000 × (1 + 0.695) = $8475). Also, the selling and administrative costs are

not included in these job costs.

Journal Entry 6

Finished goods inventory



Debit



Credit



8475



Work-in-process inventory



8475



Therefore, t he actual manufacturing cost per u nit should be c alculated, w ith t he actual manufacturing overhead, a s ($5000 + $3060)/25 pieces = ($ 8475 − $415)/25 pieces = $322.40. This

number should be used for cost of goods sold in the next section.



6.1.1.2.7 Sale of Goods

Twenty motors were sold for $700 each at the end of June. The cost of each unit sold was $322.40,

as calculated above. The following journal entries were made.

Journal Entry 7

Accounts receivable

Sales revenue (for 20 motors)



Debit



Credit



14,000

14,000



Corporate Operation—Survival Skills in Accounting and Financial Management



Journal Entry 8



Debit



Cost of goods sold (for 20 motors)



6448



Finished-goods inventory







105



Credit



6448



The difference of the amount between finished-goods inventory in journal entry 6, $8475, and in

journal entry 8, $6448, is the remainder ($1612 = $322.4 unit cost × 5 motors) in the fi nishedgoods inventory on June 30, and the overapplied overhead is $415. The cost of goods sold here has

already been adjusted by the overapplied overhead.



6.1.1.3 Accounting Schedules and Income Statements

Now, we su mmarize t he a ccounting process i n t hree E xcel spreadsheets. The schedule of cost of

goods manufactured lists the manufacturing costs applied to works in process (Table 6.1). A total

of $500 remains in raw material inventory on June 30. Note t hat t he overhead applied (predetermined overhead rate with 69.5% in MMI) is used for works in process, rather than the actual

Table 6.1



Schedule of Cost of Goods Manufactured



106







Entrepreneurship for Engineers



Table 6.2



Schedule of Cost of Goods Sold



overhead. Therefore, we added the overapplied overhead on the cost of goods manufactured, as

shown in the last line of the schedule, totaling $8475. This is the amount transferred from workin-process inventory to finished-goods inventory during June, as recorded in journal entry 6.

A schedule of cost of goods sold is displayed in Table 6.2. Th is schedule shows the June cost of

goods sold and details the changes in finished-goods inventory during the month. The final number in finished-goods inventory is based on the actual manufacturing overhead. Because the cost

of goods manufactured is estimated on the basis of the predetermined overhead rate, the overapplied overhead should be subtracted to obtain the adjusted cost of goods sold .The Excel spreadsheet

in Table 6 .3 d isplays t he c ompany’s June i ncome statement. A s t he i ncome statement e xhibits,

income before taxes is $7252, from which income tax expenses of $2901 (at a typical income tax

rate of 40%) is subtracted, yielding after-tax net income of $4351.

Example Problem 6.1

If MMI made a quote for the selling price of each motor as follows, what would the net profit be?

a. 20 motors by $600 each

b. 20 motors by $400 each

c. 20 motors by $300 each



Corporate Operation—Survival Skills in Accounting and Financial Management







107



Table 6.3 June Income Statement (MMI, Piezo-Motors)



Solution

Using the Excel Spreadsheet template in Table 6.3, by changing box G5 to 12,000, 8000, and

6000, respectively, we obtain the net profit of (a) $3151, (b) $751, and (c) $748 (income before tax

is already –$748). By equating the Sales revenue = Cost of goods sold + Selling and administrative

expenses = $6448 + $300 = $6748, we can obtain the minimum motor price (for zero profit) of

$337.40. If MMI sells the remaining motors in the finished goods inventory, the company can still

expect additional profit later.



6.1.2 Financial Statements

Afirm needs to generate their annual financial report by law, which includes the income statement,

balance sh eet, a nd cash-flow statement . The se financial st atements should be prepared ac cording

to generally accepted accounting principles (GAAP). MMI usually hires an accounting professional

such as a C ertified Public Accountant (CPA) for this preparation. Because MMI is a sm all fi rm

without common stocks, we u se here their partner company, Saito Industries, as an example to

consider the more general aspects in financial reports.



6.1.2.1 Income Statements

The income statement represents the profitability of a b usiness over a p eriod of time. This is an

extension of Table 6.3 (income statement for one project) to a 1-year period. Table 6.4 shows an



108







Entrepreneurship for Engineers



Table 6.4 Income Statement for Saito Industries, Year Ending

December 31, 20XX

(In Millions)

Sales



$100.0



Less: Cost of goods sold

Gross margin



$59.0

$41.0



Less: Selling and administrative expenses



$15.0



Less: Depreciation (building etc.)



$12.0



Earnings before interests and taxes (EBIT)



$14.0



Less: Interest charges



$0.5



Earnings before taxes (EBT)



$13.5



Less: Income tax expenses (at 40%)

After-tax net income (EAT)



$5.4

$8.1



Preferred stock dividends



$1.1



Earnings available to common stockholders



$7.0



Shares outstanding



5 million



Earnings per share



$1.4



income statement for Saito Industries in the year 20XX. Remember the necessary terminologies

and the formula:

Gross margin (Gross income) = Sales − Cost of goods sold

Earnings before interests and taxes (EBIT) = Gross margin − (Selling and administrative

(Operating income)

expenses + Depreciation)



(6.5)

(6.6)



Earnings before taxes (EBT) = EBIT − Interests



(6.7)



Earnings after taxes (EAT) (Net income) = EBT − Taxes



(6.8)



Depreciation is indicative of the potential for tax reduction arising from general wear and tear or

the obsolescence of equipment or property (building, etc.). This situation will be f urther investigated in Section 6.1.4. Net income (or net loss) represents the net profitability of the fi rm. This

is commonly referred to as its bottom line. Note also that EAT is what really counts (net income)

rather than what is earned (operating income = EBIT).



6.1.2.2 Balance Sheets

The balance sheet is a snapshot of a business at a particular point in time, as shown in Table 6.5.

It re veals fi nancial re sources t he c ompany owns ( assets), debts it owes to the others (liabilities ),



Corporate Operation—Survival Skills in Accounting and Financial Management

Table 6.5



Balance Sheet for Saito Industries as of December 31, 20XX

(In Millions)



Assets

Current Assets

Cash



$15.5



Marketable securities



$3.0



Accounts and notes receivable



$4.0



Inventories



$16.5



Total current assets



$39.0



Property, Plant, and Equipment

Buildings, machines, and equipment



$190.0



Less: accumulated depreciation



$(19.5)



Land

Total property, plant, and equipment



$5.5

$176.0



Other Assets

Receivables due after 1 year



$8.5



Other



$1.5



Total assets



$225.0



Liabilities and Shareholders’ Equity

Current Liabilities

Accounts payable



$25.0



Accrued liabilities



$6.5



Current maturity of long-term debt



$2.0



Federal income and other taxes



$12.5



Dividends payable



$1.0



Total current liabilities



$47.0



Other Liabilities



$6.0



Long-Term Debt



$27.0



Total liabilities



$80.0



Shareholders’ Equity

Preferred stock



$15.0



Common stock



$45.0



Additional paid-in capital



$20.0



Retained earnings



$65.0



Total shareholders’ equity



$145.0



Total liabilities and shareholders’ equity



$225.0







109



110







Entrepreneurship for Engineers



and its net worth ( shareholders’ equity). Assets are listed in order of liquidity, while liabilities are

listed in order of claim. The balance sheet is prepared directly corresponding to the double-entry

bookkeeping i ntroduced i n S ection 6 .1.1, Da ily A ccounting. Items on t he debit side b elong to

assets, while items on the credit side belong to l iabilities. On the debit side, accounts receivable,

raw materials, a nd fi nished-goods inventories a re shown in a ssets. On t he credit side, accounts

payable, and accrued liabilities (including wages payable) are shown in liabilities. Because of the

original double-entry principle, the balance sheet needs to maintain the equation:

Assets = Liabilities + Shareholders’ equity



(6.9)



Actually, the shareholders’ equity is adjusted to ke ep Equation 6.9; more precisely, the retained

earnings (companies’ profits) are usually adjusted.



6.1.2.3 Cash-Flow Statements

The cash-flow statement exhibits sources a nd uses of cash over a g iven period of time. Refer to

Table 6.6 for Saito Industries in 20XX. The focus is on generating income and honoring obligations (e.g., loans and other debts). It is notable that the concept of profitability is different from

cash flow. A firm’s balance sheet may reveal assets that substantially outweigh liabilities (i.e., profitability). H owever, i f t hese a ssets a re n ot c ollectible (e.g., ba d deb ts o r a ccounts re ceivable i n

Table 6.6 Cash-Flow Statement for Saito Industries, Year Ending

December 31, 20XX

Cash Flow



In Millions



Sources: Operating Activities

Net earnings



$8.5



Accounts and notes receivable



$(2.5)



Inventories



$(5.0)



Depreciation



$12.0



Accounts and notes payable







Federal income and other taxes



$(1.0)



Total



$12.0



Sources: Investing Activities

Marketable securities



$0.5



Property, plant, and equipment



$(16.0)



Total



$(15.5)



Sources: Financing Activities

Preferred stock (sale)



$3.0



Common stock (sale)



$2.5



Total



$5.5



Cash, net change



$2.0



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